Ratings

Investment portfolios and pools of the 67 Florida counties are vehicles in which local government agencies may invest their idle funds, including bond and note proceeds. Typically, the county controls the assets of a county portfolio (i.e., participation is only for various authorities of the county and is mandatory), whereas county investment pools enable noncounty-controlled entities (i.e., voluntary participants) to benefit from a pooling of assets. In other words, investment portfolios are a collection of assets that are invested on behalf of the county to maximize returns in a manner consistent with preservation of capital. All of the assets in the portfolios, made up of ad valorem taxes and other non-ad valorem receipts, belong to the counties and are under the authority of the tax collectors for public agencies. Participants in the portfolios are generally political subdivisions and county agencies such as water and wastewater, aviation, solid waste, and the like. School districts typically do not invest in the counties' portfolios, but participate in Florida's state-wide voluntary pools.

Because portfolios are made up entirely of assets controlled by the county, cash flows are well understood and can be managed accordingly. Managers of these portfolios generally know well in advance when large amounts of cash will leave and often structure their portfolios to have their bonds matured on the exact date that their participants need access to their funding. Often, because these portfolios have such predictable cash flows, portfolios are divided so that a portion of the asset base is managed to preserve liquidity, and the other portion is invested in securities with longer maturities, thus providing higher yields. Most investment guidelines preclude investing in any security with a maturity schedule of more than five years unless the Treasury or one of the government agencies with an explicit guarantee issues the security.

County investment portfolios are generally required to closely monitor the cash-flow needs of their local agencies and be prepared to meet cash needs that may arise among participants. Despite the need for liquidity, given their predictable cash flows, the majority of Florida county investment portfolios are not strictly money-market or stable net asset value (NAV) funds, subject to SEC rule "2a-7-like" guidelines. Of the 41 counties we surveyed, only six managed their portfolio along the strict investment guidelines followed by a traditional money-market fund.

In some cases, the counties run pools in which voluntary shareholders are permitted to invest alongside mandatory participants. Some counties agree to accept and invest funds from other local agencies within their boundaries. These pools can be legal repositories of investable funds for school districts. Particularly outside of Florida, it is not uncommon for counties to manage pools made up entirely of voluntary participants, although none of these types of pools existed among the counties in Florida who responded to the survey. Of the 41 counties we surveyed, 40 managed portfolios entirely made up of mandatory assets. Only Manatee County permits voluntary participants to invest in its portfolio, although the percentage was less than 5% of the assets.

We currently maintain public ratings on six Florida county investment portfolios: Broward, Hillsborough, Manatee, Seminole, St. Lucie, and Palm Beach. All of these portfolios are rated 'AAAf' for credit quality and consist, with the exception of Manatee, of 100% mandatory participants. Broward and Manatee counties carries a volatility rating of 'S1+', while Hillsborough, Seminole, St. Lucie, and Palm Beach have volatility ratings of 'S1'. The 'AAAf' ratings reflect our opinion that the portfolios' assets and counterparties provide extremely strong protection against losses from credit defaults and exhibit extremely low (for 'S1+' portfolios) or low (for 'S1' portfolios) sensitivity to changing market conditions.

Following Lehman Brothers Holdings Inc.'s (LBHI) announcement of bankruptcy on Sept. 15, 2008, the credit markets around the world virtually shut down. The Reserve – Primary Fund, a 2a-7-registered money-market fund that had a 1% exposure to LBHI paper, coupled with massive redemptions, paid out $0.97 on the dollar to investors and therefore "broke the buck." To restore confidence to investors and help thaw out the frozen markets, the U.S. government instituted a number of temporary programs directly targeting money-market funds. As of the publication of this article, the programs, all but one of which are directly targeted at restoring liquidity to money market funds, are as follows:

• Guarantee Program for Money-Market Funds: The program insures the holdings of any publicly offered eligible money-market fund so long as the fund pays a fee to participate in the program. The guarantee ensures that shareholders that were invested in a participating fund on Sept. 19, 2008, will not receive less than $1 per share on their investments, even if the fund pays out less than that amount upon redemption.
• Asset-Backed Commercial Paper (ABCP) Money-Market Mutual Fund (MMMF) Liquidity Facility (AMLF or "the Facility"): Only 2a-7-registered money-market funds are eligible to participate in the program. The program allows these funds to sell their ABCP securities to authorized dealers at amortized cost. The dealers are then permitted to access the Fed Funds window using the ABCP purchased from the money-market funds as collateral for that transaction.
• Commercial Paper Funding Facility (CPFF): This is intended to compliment the AMLF and provide a liquidity backstop to U.S. issuers of commercial paper that meet certain guidelines through a special purpose vehicle (SPV) that purchases three-month unsecured and ABCP directly from issuers.
• Money-Market Investor Funding Facility (MMIFF): This is designed to support a private-sector initiative with the goal of providing additional liquidity to 2a-7-registered money-market funds. JP Morgan Securities Inc. is the manager of the five newly created SPVs that are permitted to buy specific commercial paper, bank notes, and certificates of deposit with maturities of 90 days or less directly from money-market funds as long as they meet a variety of qualifications.

All of these programs generally are targeted at the 2a-7-registered money-market funds that fall under the SEC's jurisdiction. Nonregistered "2a-7-like" funds, including offshore funds and local government investment pools and county portfolios, are typically excluded from participation in any of the government programs.

While the Florida county portfolios, county pools, and state-wide pools are not direct beneficiaries of any of these programs, they have indirectly benefited from the unfreezing of the credit markets following the government's actions. Following the establishment of these programs by the Treasury and the Federal Reserve, yields on commercial paper and other short-term debt typically held by portfolios and pools in Florida have narrowed and have become more liquid. Although total normality has not yet returned to the credit markets, the programs instituted by the government, in our opinion, have reduced the uncertainty and illiquidity of the short-term credit markets following LBHI's default.

Evolving financial markets result in a broader menu of investment options, some of which are complex. Along with other institutional investors, investors of county assets are faced with holding assets that could entail unexpected credit exposure, market value declines, or severely constrained liquidity, making the determination of market value difficult. In light of the turmoil in the credit markets and given the fact that most county portfolios in Florida are not rated, our survey seeks to provide a degree of analytic interpretation of how much exposure to these risks the portfolios have. In addition to providing county investment portfolio statistics such as market and book values, we explored aspects of investment management practices and the extent to which the counties invested in various investment instruments are prone to credit and/or liquidity risk.

Similar to other investors, counties are subject to market conditions, particularly the interest rate environment. Unlike some investors, however, counties also face relatively inflexible cash outflow needs and serve a highly important role as the keeper of assets used for local entities' day-to-day operations and special projects. Our review, therefore, considered whether and to what extent the county portfolios held asset types that have recently demonstrated strain through limited liquidity, weakening credit, or declining values.

Our survey was conducted before the default of LBHI and so we are unable to determine if and to what extent counties experienced loss as a result of exposure to that name. We are aware of at least two cases (Sarasota County and The Florida State Treasury), in which counties or pools suffered losses due to their investment in LBHI. The survey of county portfolios attempted to uncover whether they invested in any of the following:

• ABCP;
• Auction-rate securities;
• State Board of Administration's Local Government Investment Pool;
• SIVs–-Open-ended (ongoing) investment entities designed to be bankruptcy remote and to generate returns for investors by funding exposure to long-term securities and asset purchases by issuing a mix of short-term debt, CP, and medium-term notes.

We also surveyed key investment policies and practices to understand not just the portfolios' exposure to currently or previously distressed investments, but also to better comprehend their ability to withstand future stress in the market. By examining whether certain practices known to either enhance or minimize risk exposure were present, we sought a broader perspective that may indicate an investment portfolio's orientation to manage market risk. Among the various practices surveyed were:

• Is the portfolio managed along the lines of a money-market fund (i.e., is it a 2a-7-like fund)?
• How often (weekly, monthly, etc.) are the securities in the portfolio marked to market (i.e. obtaining a value to a position based on the current market price)?
• Do investments include repurchase agreements? If yes, what is the policy regarding collateral type, maturity, margin, etc.?
• Is securities lending of the portfolio's assets permitted?

Several features of the current environment in Florida could explain why managers of county portfolios might be tempted to search for higher yields. First, a slumping housing market and fear of a prolonged recession is resulting in widespread softness among economically sensitive revenues for many local governments. Local governments in Florida generally have a diverse revenue mix, but their revenue raising flexibility for ad valorem taxes has been curtailed following Amendment 1 to the state constitution.

When revenues decline, governments will balance budgets through spending cuts, use their reserves, or turn to alternative sources for revenue replacement, such as a high return on their investments. Second, the counties' complete control of the assets in their portfolios and the resulting predictable cash-flow schedule might lead portfolio managers to take on additional risk if they have no fear of "hot money" leaving their portfolios unexpectedly. Third, low interest rates make it a challenge to keep even with, let alone outperform, prior returns. However, despite the falling county revenue base and pressure to perform well, the county portfolios we surveyed and state-wide pools we rate have focused on safety and liquidity instead of yield.

The past year's market events have affected nearly all types of fixed-income portfolios, but our survey indicates that most portfolios and pools remained well within their stated guidelines and continue to invest very conservatively. Six out of the 41 counties surveyed responded that they manage their portfolios along the lines of 2a-7-like money-market funds. As per their mandate, these portfolios typically invest in highly rated securities, maintain a weighted average maturity (WAM) of 90 days or less, and follow diversification guidelines limiting their purchases to 5% exposure per issuer except for entities the U.S. government fully supports.

Although the remaining portfolios surveyed do not explicitly follow the 2a-7 guidelines, we found their portfolios to be generally conservative. The majority of the portfolios' assets are invested in government agencies, including agency mortgage-backed securities and treasury securities that offer safety and liquidity to the county while posing no credit risk. It is not uncommon for a county to invest 100% of its portfolio in these securities. For slightly higher yields, some counties may invest in commercial paper or highly rated corporate bonds. Many counties, however, require that these investments meet the designation as a Florida QPD. In addition, despite the misconception prevalent in the market prior to last year that auction-rate securities are as safe as money-market funds, the majority of counties we surveyed never invested in these instruments. Only two out of the 41 we questioned currently have exposure to these now generally illiquid investments.

The majority of Florida's county portfolios do not engage in securities lending programs. Although many investment guidelines permit these programs, only two out of the 41 counties surveyed utilize securities lending. Those two generally do so as a means of generating a steady stream of income by lending out their treasury and agency securities and receiving securities as collateral, rather than as a leveraging technique where cash collateral is received and reinvested to enhance return. When used as leverage, the portfolio/pool is subject to additional investment risks and therefore should have specific operation guidelines to manage the pool/portfolio exposure.

Because of the counties' liquidity needs, most portfolios are structured so that investments mature on the same dates that cash is needed. As a result, in many cases a smaller percentage of the portfolios generally mature either overnight or in 30 days or less, whereas the majority might be invested in longer maturities. Whereas the WAM of "2a-7-like" portfolios are kept to less than 90 days, the average WAM of all the counties surveyed was 159 days. The longest WAM was 760 days and the shortest was one day, as some counties opted to maintain a portfolio completely invested in overnight paper to ensure daily liquidity at all times. On average, 53% of the counties that responded had portfolios that matured in 90 days or fewer.

Counties use a variety of instruments to provide liquidity to their portfolios. Some invest in paper that matures daily--such as overnight commercial paper--or structure their portfolio so that a certain percentage matures every day. Many keep a small percentage of their assets in overnight bank deposits with highly rated or QPD banks at all times (generally earning the same rate as Fed Funds) to meet the county's daily liquidity needs. One other common investment to provide liquidity is repurchase agreements (repos). Thirteen out of the 41 portfolios we questioned currently invest in repos, although investment guidelines permit many more to do so. When utilizing repos, most portfolios are highly conservative in their investment approach. Most require that the counterparty bank or the broker/dealer meet the designation as a QPD. Thirty-nine out of 41 required that either treasuries or agency paper be used as collateral to back the repos. In addition, the collateralization levels the counties mandated were consistent with those that money market funds use, ranging from 100%-102% for treasury collateral and 102% for U.S. agency paper.

We found that counties value or obtain the market price of all holdings (i.e. mark to market) much less frequently than money-market funds and other fixed-income funds typically do. "2a-7-like" funds generally use marked-to-market pricing on their portfolios weekly, and in some cases even daily. Seventeen of the counties we surveyed reported performing mark-to-market pricing monthly, eight did so annually, and four priced quarterly. Counties that mark to market annually did so for ease of accounting. Because there are no outside shareholders in the majority of county portfolios, official calculation of the investments' NAV less frequently is generally sufficient. Although official pricing is often infrequent for county portfolios, portfolio managers are able to monitor valuations of their assets through their broker/dealers or other systems such as Bloomberg. Thirteen counties surveyed do not officially mark their portfolios to market, mainly because of the limited investments in their portfolio and the mandatory nature of their assets.

We found that the majority of counties surveyed had no realized losses in their portfolios. In addition, few counties have been faced with downgraded or illiquid securities. Most of the counties who responded do not invest directly in asset-backed securities (ABS), ABCP, or SIVs. Only six of the counties surveyed continue to have exposure to SIVs, all of which is through the SBA. Out of the 41 counties surveyed, 16 have investment guidelines that permit the purchase of either ABS or ABCP. Of those, 13 purchased ABS/ABCP before the credit crisis began in August 2007, but only six have purchased this type of paper since then. Currently, only four of those six have exposure to ABS or ABCP. None of the counties surveyed plan on buying SIVs in the future.

Despite their overall conservative investment approach, we found that 10 counties are currently exposed to downgraded securities, although it was unclear from our results how many of these are through their investment in SBA LGIP B. The average exposure to these securities represents less than 1% of the total portfolio. Seven counties incurred a realized investment loss due to downgraded securities. Those losses were minimal, ranging from 0.01% to 0.13% on a security basis, representing only a small fraction of the overall portfolio.

Because of the unprecedented volatility in the market, some counties have unrealized losses in their portfolios. An unrealized loss occurs when the price of an asset decreases from its purchase price but continues to be held (i.e., not sold) by the manager. The portfolio therefore does not realize the loss. We found that deviations in market value versus book value, or the unrealized/realized gains or loss, were consistently low among the surveyed counties. The average maximum monthly percentage fluctuation in market value from the original book value of the investment portfolio during the past six and 12 months was 1.72% and 1.84%, respectively. Only two of the 41 counties indicated they would consider using the county's general fund to purchase investment portfolio assets with depressed valuation.

Although some counties are faced with a small exposure to downgraded and less-liquid securities, the generally conservative guidelines and overall approach taken by the county portfolios' managers have enabled them to avoid much of the turmoil in the credit markets during the past 18 months. Despite the material disruption in the credit markets in September 2008, county portfolios have continued to provide for the safety and liquidity needs of their participants.

We believe that county portfolios will maintain their investments in conservative options such as treasuries and agency paper, and will maintain the structure of their portfolios to meet their participants' liquidity needs. In the months and years ahead, we expect a continuation of the conservative approach we have observed. Further restrictions on security types that could prove to be less liquid during times of instability in the financial markets are possible.

Florida County Investment Portfolios 2008 Survey Findings*
(Representing the 41 out of 67 counties that responded to our survey)
County	Book Value ($)	Market Value ($)	Market Value/Book Value	Effective Duration (years)	Weighted Average Maturity (Days)	Assets Maturing <90 Days (%)
Alachua	218,518,283.00	217,931,141.00	99.73			70.59
Baker	6,000,000.00	6,000,000.00	100.00		180
Broward	2,517,715,000.00	2,520,060,000.00	100.09	0.71	481.8	41.00
Calhoun	3,000,000.00	3,000,000.00	100.00
Charlotte	471,949,001.00	470,618,161.00	99.72	0.75	450	47.00
Citrus	57,449,868.73	57,428,938.70	99.96	0.415	151.475	61.00
Columbia	25,000,000.00	25,000,000.00	100.00		1	100.00
Duval	718,220,874.00	712,146,042.00	99.15	1.52	6.7	28.00
Escambia	223,466,569.00	223,517,755.00	100.02	0.24	107	74.00
Flagler	37,000,000.00	37,000,000.00	100.00	0.07		100.00
Gadsden	14,094,023.00	15,325,724.00	108.74	<1
Gulf	10,000,000.00	10,000,000.00	100.00		1	100.00
Hernando	202,494,313.06	205,499,134.89	101.48	1.48	590	34.90
Hilsborough	1,855,870,357.00	1,861,079,977.00	100.28	1.106	269	44.44
Indian River	335,954,721.00	338,292,568.00	100.70	2	420	11.00
Lafayette	2,000,000.00	2,000,000.00	100.00		1	100.00
Lake	317,456,289.00	317,795,398.00	100.11		365	45.00
Lee	1,221,951,196.00	1,223,609,183.00	100.14	0.28	270	24.66
Leon	223,757,652.00	223,202,474.00	99.75	0.97	489	45.00
Madison	2,500,000.00	2,500,000.00	100.00		1	100.00
Manatee	689,364,190.00	691,555,218.00	100.32		245	44.06
Marion	160,662,708.00	160,662,708.00	100.00	1.17		32.00
Martin	246,867,167.00	248,362,599.00	100.61		170	85.63
Miami-Dade	4,432,083,393.00	4,451,052,516.00	100.43	0.213	163	5.24
Nassau	95,452,533.00	95,244,298.00	99.78		<90	100.00
Okaloosa	115,000,000.00	115,000,000.00	100.00	0.24
Osceola	409,801,964.00	410,999,632.00	100.29	1.5	616.85
Palm Beach	1,828,008,225.00	1,826,712,192.00	99.93	2.74		12.80
Polk	795,108,193.00	795,237,123.00	100.02	0.83	343.1	60.00
Putnam	35,000,000.00	35,000,000.00	100.00	0.285		75.00
Santa Rosa	69,467,023.00	69,467,023.00	100.00		<365
Sarasota	831,800,000.00	835,304,000.00	100.42	1.27		30.00
Seminole	691,800,000.00	693,600,000.00	100.26	2.06
St. Johns	102,767,247.00	103,700,645.00	100.91	1.59		10.00
St. Lucie	364,157,711.00	364,061,294.00	99.97	2.01	760	32.00
Volusia	531,895,896.28	534,029,950.00	100.40			58.26
Wakulla	9,733,749.00	9,733,749.00	100.00			11.00
Walton	85,221,008.00	85,221,008.00	100.00	4.7		15.00
Washington	5,000,000.00	5,000,000.00	100.00		1	100.00
*Valuation date: June 30, 2008.